Mortgage Rates: How High Will They Go After Fed Retreats?

Of all the extraordinary ways the Federal Reserve mainlined dollars into our economy to stave off a second depression, its biggest program by far was the 18-month, $1.25 trillion purchase of mortgage backed securities (MBS). These securities are pools of thousands of individual mortgages, packaged and auctioned off to investors, to pay a steady rate of interest, much like bonds. When investors stopped buying in the credit crisis, Bernanke backed up the truck and started loading up. On April 1, he's planning to close the door and drive away. (On March 16, the Fed confirmed its plans to stop buying mortgage-backed securities).

The Fed’s purchase program was designed to keep mortgage rates low and stable, and to keep banks lending, and it worked. Though lending standards have generally gotten stricter, mortgages are readily available to qualified buyers, and 30-year fixed rates have hovered around 5 percent for more than a year-and-a-half. Once the economy started to recover, however, the Fed has said that it would end its purchase program on March 31, and the timing and specifics of how the Fed pursues its exit strategy are likely to have a profound effect on the economy and your financial life. One thing’s for sure, though: The interest rate you pay to buy a house or refinance a mortgage will almost undoubtedly start to go up around April Fools Day.

That’s because the Fed’s massive purchases have been a stand-in of sorts for private investors. Scared off from the mortgage markets during the financial crisis that began in 2007, these investors, mainly large institutional money managers and investment banks, are just now beginning to step back in as the Fed steps out. But where the Fed was content to play caretaker, private investors will demand profits, and won’t be acting as monolithically as the Fed. As a result, mortgage rates will likely increase, as will their volatility.

Mortgages at ‘Rock Bottom’

Just how high rates will go, however, and when they’ll start to move, isn’t yet clear. Lawrence Yun, chief economist for the National Association of Realtors (NAR), says 30-year fixed rates are “rock bottom” and simply cannot stay at 5 percent. That much, economists, analysts, and the Fed all agree on. But just how high they’ll get is another question.

Fed Vice Chairman Donald Kohn told a conference last month that any increase in rates is likely to be “modest” but added “that judgment is subject to considerable uncertainty.” Yun believes 30-year fixed rates will probably end up jumping to about 5.7 percent by year’s end. Freddie Mac, which issues many of the MBS being bought by the Fed, said in late December that rates would hit 6 percent by the end of 2010, sending a shock through the market. But Amy Crews Cutts, Freddie’s deputy chief economist, now foresees a rate increase more in line with Yun’s prediction, saying that any upward pressure on rates will likely be offset by a dropoff in demand. Bill Gross, head of Pimco, one of the largest and earliest private investors in mortgage-backed securities, believes that due to a rising interest rate environment in general, mortgage rates could settle anywhere between 6 to 6.5 percent, but admits at this point he’s simply making an educated guess.

Economist David Rosenberg of investment firm Gluskin Sheff also estimates that rates will end up north of 6 percent. Rosenberg is notably dour on the economy — he gave President Barack Obama an “F” for his handling of economic matters in a recent MoneyWatch report card — but as he explained in a recent paper, his prediction is based primarily on the fact that the era of “unbelievable support for the housing market” by the Fed is coming to a close.

Rosenberg emphasizes that this will lead to “heightened volatility in all the markets,” so if you’re a homebuyer, the rate you qualify for when you start shopping for a house could be significantly different than the rate you end up with by the time you sign your mortgage. As a result, locking in a rate makes a lot of sense.

On a $300,000 loan, the difference between a 5 percent rate 6.5 percent is $300 per month, or nearly $100,000 over the life of the loan. So if rates do head higher, those larger monthly payments will squeeze buyers and could cause housing prices to fall.

Feds Trying to Keep Rates Low

Despite the looming end to the Fed’s MBS program, Bernanke and the Obama administration remain open to extraordinary measures. They’ve both expressed a clear desire to keep interest rates low, even if private investors don’t materialize, or if those investors demand ruinous rates of return on the MBS's they are willing to buy. Even now, government entities Freddie Mac and Fannie Mae have announced they will spend considerable money to smooth the functioning of the MBS market. And if those moves fail to spur private investors’ return to the market, the Fed itself has signaled it would consider restarting its purchase program later this year.

The bottom line is that housing is just a far too large and interconnected sector of the economy to risk damaging any further. That’s why even pessimistic economists can’t imagine mortgage rates above 6.5 percent right now, and why Fannie and Freddie and ultimately the Fed are all ready to step back in should things falter, and are proceeding with such caution. Getting it wrong could worsen the unemployment picture and even spark inflation, setting the recovery effort back by years. “Housing is just so important for broader economic recovery,” says NAR’s Yun. “To pull the plug now would be a huge wasted effort over the past year, to start at page one again.”

What this means for you is that if you’re going to buy or refinance a home, interest rates probably aren’t going to get lower than they are right now, but don’t panic: They’re also not likely to get too high, either. And of course, there is one last thing to consider: the price of a home itself. The latest Case-Shiller Home Price Index report from Standard & Poors shows that national home prices continued to decline in the fourth quarter from a year earlier, although at a much slower rate — 2.5 percent — than previously. (Keep in mind that different markets are seeing very different price movement: San Francisco is up; Vegas is down.) So even if you qualify for a rock-bottom rate buying may not be worthwhile in the near term. Especially not if you end up being underwater on your brand new mortgage.